The Intelligent Investor: Stock Selection for the Enterprising Investor

intelligentThis is the sixteenth in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the fifteenth chapter, which is on pages 376 to 395, and the Jason Zweig commentary, on pages 396 to 401.

As I mentioned last week, this chapter (and the one preceding it) form what I consider to be the heart of The Intelligent Investor.

What I found most interesting about the previous chapter – Stock Selection for the Defensive Investor – is that Graham basically advocates for index funds if you’re a defensive investor. The interesting part is that Graham wrote that chapter in 1972 – years before index funds appeared for people to invest in. They simply didn’t exist in 1972 – the only mutual funds around at that time were heavily managed by active investors.

This chapter, though, sees Graham talking about individuals who aren’t simply defensive in their investing. How does one seek out and find value stocks, not just ones listed in the S&P 500? Graham really answers that question here.

Chapter 15 – Stock Selection for the Enterprising Investor
So, how do you find a value stock? That’s really the question Graham strives to answer in this chapter.

The first factor to look for is a low price to earnings ratio – information you can easily get from a good stock tracking software like the Yahoo Stock Screener (that’s the tool I use). Graham suggests looking for stocks that have a price-to-earnings ratio of 9 or lower.

Graham immediately points out that simply screening based on a P/E ratio of less than 9 will get you a lot of stocks – and he’s right. I found 909 stocks that had a P/E ratio of 9 or less – a mix of big companies and little ones, ones I’d heard of and ones that I hadn’t.

Graham then suggests five additional factors to screen for:
1. Good financial conditions – assets that are at least 1 1/2 times current liabilities
2. Earnings stability – no losses in the last five years
3. Dividends – some current dividend is being paid
4. Earnings growth – last year’s earnings are more than those of five years ago
5. Price – a stock price less than 120% of the company’s assets

I entered some of these criteria into the tool and found that these factors quickly eliminated hundreds of stocks, leaving me with a much tighter list with companies like Exxon and Chevron to investigate.

Much of the rest of this chapter deals with special situations, most of which Graham encourages people to avoid (“special” issues) or has a lot of caveats about (buying stocks with a stock price lower than the company’s assets – probably meaning the company is in fairly serious trouble).

Commentary on Chapter 15
Zweig actually extracted different lessons from this chapter than I did, which speaks to the density of information in Graham’s writing – and probably indicates why many people have a hard time trudging through the book.

Zweig argues that the biggest lesson here is the value of practice. Graham’s pointers seem straightforward at first glance, but they really only help you find a group of stocks which you’ll have to dig through on your own. The process of digging through those stocks, picking a few, seeing how they do, and learning some of the patterns is something that can’t really be taught in a book – it requires a lot of experience.

How can you get that experience? Zweig strongly encourages people to spend some serious time (he suggests at least a year of practice) using an online portfolio tracker like the one at Yahoo. Study stocks, add some to your virtual portfolio, and watch them. See what works and what doesn’t. If you enjoyed this process and earned a decent return, start investing with real money – but if you just wind up confused and bored, stick with index funds.

Next Friday, we’ll take a look at Chapter 16: Convertible Issues and Warrants.

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